Financial Awareness: Do You Understand Your Company’s Metrics (KPIs)?
Key performance indicators (KPIs) are quantifiable measures of performance against defined targets, objectives or industry competitors. KPIs are generally spoken of in terms of financial data. They quantify financial outcomes such as revenue growth, profit margin and operational cash flow.
KPIs can be used at organizational, department, team and individual levels. For example, at the individual level, you can create a KPI around productivity to monitor and enhance employees' performance. At the department level, you can determine KPIs that measure and reflect key outcomes you're responsible for. As an example, your sales team can choose 'conversion rate' as a KPI to track the number of new leads that convert to customers.Different types of KPIs can be envisioned in this way. For the purpose of this post, we will limit our focus to financial KPIs.
Why is it important to know the financial status of a business and how are KPIs useful in this regard?
KPIs provide an objective way to evaluate and improve companies’ strategies, operations and investment decisions. It is in entrepreneurs' interest to understand whether their company is doing well financially. KPIs and performance management go hand in hand. A performance management system is a mechanism for tracking company performance measurably by using a set of relevant KPIs.
By maintaining a strategic focus on the chosen performance measures, you can implement appropriate strategies, provide a fair and consistent performance management system, and unite the individual employee around key objectives. To ensure that everyone understands their company's strategic focus, financial awareness around the common financial KPIs is paramount, for they're likely to encounter them during discussions and in reports of company performance. It also creates a desire to know the company's financial status, asset base and performance relative to competitors.
For example, you may be aware that your company has gained several big-ticket clients in the past quarter. The gain may reflect in the revenue growth. But, hold on, you see that profit has declined over the same period. What gives? You dig a bit deeper and find out that the lower profit was due to higher costs: wage hikes, overseas hiring and currency appreciation against the dollar.
Knowing what the numbers stand for is a good start to gauging how your company is doing. An understanding of why the numbers rose, fell or remained flat provides useful insights into the short- or long-term outcomes of your company's strategies, your company's overall financial health, and how it is financially positioned for the future.
How to use KPIs
- Monitor your company's health
- Measure progress
- Analyze patterns over time
- Identify opportunities or solve problems
- Make quick adjustments.
Common Financial KPIs
There are different types of key performance indicators. Companies may use various KPIs, based on their industry and business objectives. Here are the common KPIs to know in order to improve your financial awareness:
1. Return on Assets(ROA)
Return on assets is a financial indicator measuring the profits your company earns from its overall resources. It tells you how efficiently you're able to utilize your economic assets to generate earnings.
ROA = Net income/Total assets
A rise in ROA over time indicates that your company is extracting profits from every dollar it spends on its assets. A low ROA shows that your company is struggling to convert the investment in its assets into profits.
This KPI provides an understanding of:
· how your company is managing its assets, liabilities and equity to generate profits;
· current financial status and potential for future growth compared to competitors; and
· the management's ability to capture opportunities relative to available assets.
2. Return on Equity(ROE)
Expressed as a percentage, return on equity measures your company's profitability in relation to its shareholders' equity. It indicates how ably your company is generating returns from investments received from shareholders. ROE is one of the metrics that stock market investors use to compare stocks in the same industry.
ROE = Net income/Stakeholder's Equity
3. Revenue Growth
Healthy sales are critical to business sustainability and success. Revenue growth is the increase or decrease in a company's sales over time, such as from one quarter to another. It is expressed as a percentage.
Revenue growth = (Revenue in current period - Revenue in previous period)/Total revenue in the previous period
4. Working Capital
Having sufficient funds on hand offers businesses the flexibility to invest in projects, while acting as a safety net when clients default on payments or the market is in a terrible state. By proactively tracking your company's working capital, you can step in as needed to keep operating liquidity above a targeted level, so as to more easily pursue opportunities, improve efficiency and insulate against external headwinds.
Working capital = Current assets - Current liabilities
5. Gross profitmargin
Gross profit is the money the company makes after deducting the costs associated with making its products/goods or providing its services.Dividing this number by the revenue gives the gross margin made on a percentage basis after accounting for the costs to deliver the company's primary product/service (COGS, cost of goods sold), not including other costs such as payroll, rent, utilities and so on. Your company will be aiming to improve its gross margins, that is, increase its revenue while decreasing costs to deliver goods or services.
Gross Profit Margin = (Revenue - COGS)/Revenue
6. Net Profit Margin
Net profit margin is the revenue remaining after deducting operating costs, interest and taxes from the total revenue. It takes into account all outgoing costs, including COGS, and includes investment income, debt payments, one-time payments and income from secondary operations. Net profit margin is expressed as a percentage.
Net Profit Margin = (Revenue - Cost)/Revenue
7. Debt ratio
The debt ratio indicates the level of debt your business has versus its total assets. Savvy businesses aim to keep their debt ratio low while also using debt to grow their business. A high debt ratio can turn away investors and creditors.
Debt Ratio = Total Debts/ Total Assets
As you can see, KPIs can be raw numbers (e.g.: We lost $5,000in potential revenue last week owing to the snap lockdown), percentages (e.g.:Revenue from new products grew 12% in the last 30 days), ratios (e.g.: Our small business has a debt-to-equity of over 2, which can make it appear risky to investors).
Apart from these common financial metrics, you can enhance your knowledge of other KPIs to [think like a manager] and make better business decisions.
How KPIs help grow financial awareness: Three examples
KPIs are not just for the finance department!
You've been promoted to business team leader and the manager asks you to check whether spending is on track. What KPI would you refer to? Line of business(LOB) expenses versus budget compares your actual overhead with the budgeted amount. So, it should give a good idea of whether the business is on or offtrack with regards to its spending. If you've deviated from the budget, then here is your chance to sort it out.
The pandemic lockdown has affected some of your customer sand you suspect that you might have issues in the receivables area. Unless you take action quickly, it won't be too long before you start facing a liquidity crunch. You look at the accounts receivables turnover, the rate at which your business is collecting what it is owed by customers. You then identify customers that are taking too long to pay, chase payments over the phone and email, and make appropriate modifications in managing receivables so you're better off during a future challenge.
A healthy cash flow is crucial to your entrepreneurial venture. A KPI to track the total capital you have in use is necessary to ensure that you're not spending more than you have coming in. Operating cash flow, the amount of money your business brings in from regular operating activities, is a suitable KPI to track. A ratio of the operating cash flow to the total capital or funds you've employed will help you make astute decisions on the areas to invest your capital.
Make financial KPIs easy to understand with BALINCA
Financial metrics are among the key financial awareness topics for employees, entrepreneurs and students alike. Given their value, you can benefit tremendously from understanding the financial KPIs on income statements, balance sheets and cash flows.
BALINCA's experiential simulation is an effective, immersive and enjoyable approach to learning KPIs. We provide a safe space for making mistakes and encourage you to experiment with business finance. Come, discover the meaning behind the numbers and use insights to maximize your company's advantage!